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Can the financial services industry stave off the next credit crisis?

Credit risk management at banking, securities, and insurance companies worldwide has improved in the wake of the financial crisis in 2008 and the sovereign debt crisis that followed in the euro zone, but the improvements were not enough, according to research by the Swiss-based Joint Forum, an international group of regulators that deals with issues common across all three financial services industries.

The crises triggered fundamental changes in market behaviour and regulatory requirements, which brought about new challenges and risks, the Joint Forum report on developments in credit risk management suggested.

“Continued financial risk-taking and structural changes in credit markets are shifting the locus of financial stability risks from advanced economies to emerging markets, from banks to shadow banks, and from solvency to market liquidity risks,” the International Monetary Fund reported in April, based on survey results that also looked at credit risk management after the back-to-back debt crises.

The Joint Forum’s two surveys of 15 supervisors and 23 banking, securities, and insurance companies in Europe, North America, Asia, and Africa found that new regulatory requirements and lessons from experiences during the past seven years led to more stress testing and a search for more sophisticated approaches to model credit risk. Companies also reported aggregating watch lists of counterparties, industries, and countries under credit stress and moving away from relying on external credit rating agencies.

In particular, international banks in Europe lowered their credit risks in the wake of the crises by reducing cross-border lending, which is sensitive to global shocks, the IMF report indicated. Local and regional banks partly made up for the reduction with local affiliates’ lending more, which had the stabilising effect of deepening links within regions.

The research also pinpointed credit risks that have cropped up because of the regulatory and market changes of the past seven years:

The search for yield. The current low-interest-rate environment has triggered a search for investments with higher yields, which has financial services companies raising their risk tolerance. In particular, life insurance companies, which have long-duration liabilities to match, are increasingly seeking risky assets for their investment portfolios.

Stress tests conducted by the European Insurance and Occupational Pensions Authority show that 24% of insurers may not be able to meet their solvency capital requirements under a prolonged low-interest-rate scenario, according to the IMF report. The industry has a portfolio of €4.4 trillion (nearly $5 trillion) in assets in the EU, with high and rising interconnectedness with the wider financial system, creating a potential source of spillovers.

Over-the-counter derivatives. In the wake of the crises, financial services companies have increasingly lowered the risk of over-the-counter derivative transactions by involving collateral, also called an increased use of margin. This is partly the result of regulatory changes, such as the European Market Infrastructure Regulation and the Dodd-Frank Wall Street Reform and Consumer Protection Act in the US.

In 2013, 91% of over-the-counter-derivative trades globally were subject to collaterisation, according to the Joint Forum surveys. But respondents were concerned that demand for collateral of high quality and liquidity is outstripping availability. Also, companies are reporting that costs associated with obtaining letters of credit have increased as a result of creditworthiness concerns.

Central counterparty (CCP) clearing houses. CCPs help facilitate trading in European derivatives and equities by ensuring the performance of contracts between buyers and sellers. Safe and efficient CCPs help maintain and promote financial stability, but they also concentrate risk and can be sources of financial shocks if not properly managed, according to the Joint Forum report.

Also, some instruments cleared by CCPs are associated with greater risk than others.

To better manage the new credit risks, the Joint Forum offered financial services companies four recommendations:

Evaluate simple measures in conjunction with sophisticated modelling to get a more complete picture of credit risk management and regulatory capital.

Consider risk-management processes that monitor companies’ search for yield in a low-interest-rate environment.

Prepare for the growing need for high-quality liquid collateral to meet margin requirements in the over-the-counter derivatives sectors.

Make sure to accurately capture CCP exposures as part of credit risk management.

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